Choice of Economies, a Followup

In this post, I attempted to ask the question as to what criterion should be used to prefer one economy over another.

My answer to that question would involve the actual supply and consumption of goods and services, the purpose of any economy. If one economy results in a larger consumption of every good and service for every individual than a second economy, then the first economy must be preferred. The fact that this is much too strong a requirement to be useful in comparing two economies chosen at random doesn't invalidate its essential truth.

In particular, consider two economies as follows :

The first economy has direct supplier competition for every good and service and the final consumer price for every good and service approximates the marginal cost of production.

The second economy has only a single supplier for every good and service and final consumer prices for every good and service are those which maximize supplier profits.

It will generally be true that the final consumer prices for maximizing supplier profits will be greater than final consumer prices at marginal cost, for otherwise the supplier will be selling below marginal cost and exit the business sooner or later.

It is commonly believed that low final consumer prices are an unalloyed benefit, and this is reflected in efforts by government to prohibit the existence of sole supplier markets. This is a mistake. The purpose of prices is translate the subjective preferences of consumers into quantitive supplies of arrays of product offerings and to allocate the efficient use of the resources used in their production. The carrying out of this purpose depends on relative prices, not absolute prices.

The difference between the two economies described above is fundamentally what drives the choice of what final consumer goods to produce in what quantities.

If prices are determined by marginal cost, then it is the technology and productivity involved in the recipes of resources employed in the production of a given consumer good that is the driving force.

On the other hand, if prices are determined by supplier profit maximization, it is primarily the subjective price/demand schedules of individuals that determine the choice of goods and their quantities produced.

To see this, assume for simplicity that a given product has a zero marginal cost of production. For a single supplier in this case, profit maximization is the same as revenue maximization. If a supplier sets a price of zero, he will see a large unit demand, but zero revenue. If he sets a price so high that there is no unit demand, there will again be zero revenue. Thus it is a mathematical and logical certainty that at least one intermediate price exists which will produce a revenue that can be improved upon by no other price. This intermediate price is entirely the result of the subjective preferences of consumers that result in an aggregated price/demand schedule. The result is that price for which consumers in total are willing to spend the most on a given good.

There is no reason that we cannot imagine that both types of economies may be producing the exact same array and quantities and distribution of goods at one instant in time. One question is what evolutionary path is present for each type of economy.

For the profit-maximizing economy, the higher level of profits are available for re-investment in new products and for productivity-enhancing investments for the production of existing products. The higher level of profits possible result in more entrepreneurs being willing to take on the risks of new ventures. As consumer preferences change, prices and production quantities track along to keep profits maximized.

For the marginal-cost economy, re-investment possibilities are limited by both lower profits and lower potential rewards. Far fewer entrepreneurs will respond to the smaller incentives for new ventures. Simple improvements in the production recipes for goods cannot be retained as profits, but must result in lower specific prices, disrupting the existing preferred consumption pattern of consumers.

It seems clear to me that the profit-maximizing economy will easily outpace the marginal-cost economy in the future production and consumption of goods and services.

Note that the apparent higher consumer prices of the profit-maximizing economy also result in higher wages and other factor prices as they tend to earn their discounted marginal revenue product.

Also note that profit-maximization over time requires prices set far enough below instantaneous maximizing levels to discourage new entrants. Potential competition should be adequate to control prices and quality, and yet not require all the duplication of fixed costs (palatial headquarters complexes and high-priced executives for example) required by actual direct competitors.

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Let me quote two sentences

Let me quote two sentences from the post:

"If one economy results in a larger consumption of every good and service for every individual than a second economy, then the first economy must be preferred." (preference criterion)

and (for a product with zero marginal cost of production):

"The result is the price for which consumers in total are willing to spend the most on a given good"

Inferences about maximization of *spending* on a particular good (second sentence) do not allow the estimation of (real) maximum preferred consumption. In the example at hand, if the marginal cost of production is zero, then the good could be produced in very large quantities, and distributed at zero price, e.g. as an advertising tie-in, charity or for other ideologically-driven (rather than profit-driven) purposes. Assuming large numbers of suppliers, the actual consumption would be maximal and would accurately reflect the preferences of consumers. This is in stark contrast with profit-maximization for a single supplier, where consumption would be limited by a non-market price (i.e. a price which is not the result of interactions of multiple independent pairs of decisionmakers). This line of thought can be illustrated by the differences in the consumption of religious writings, e.g. Bibles, whose distribution is not in the least limited by production price, but exclusively through limited demand, compared to some copyrighted materials, whose consumption is limited by price.

For the above and other reasons, I disagree with the conclusion of the post: economy B will in fact be inferior to economy A, specifically using the preference criterion quoted above, with which I happen to agree wholeheartedly.

The issue of exactly what methods are to be used to prevent formation of monopolies in economy A is somewhat orthogonal to the recognition that monopolies are harmful under the preference criterion, but let me mention that I consider government enforcement of anti-trust laws to be largely counterproductive. As Richard Epstein points out in his "Simple Rules for a Complex World", there are many ways of preventing monopolies which do not rely on the government, and for a libertarian like me, this should suffice.

Rafal

Rafe, It seems to me that

Rafe,

It seems to me that you may have mis-interpreted a part of my post and as a result, there are parts of your comment which I cannot understand.

I only intended to use zero marginal cost in the case of a single supplier, and then only to equate profit maximization with revenue maximization. The actual profit-maximizing price for a single supplier is the revenue-maximizing price plus a fraction of the marginal cost, one half if the price/quantity demand curve faced is linear above the maximum revenue point.

I disagree if you are saying that the profit-maximizing price set by a single supplier is a non-market price.

I'm not sure which economy you are preferring, profit-maximizing or marginal cost, as I have abandoned the use of A and B labels in this post.

I disagree that monopolies only defined by a single supplier condition are either injurious or need to be prevented, as long as new entries of competitors are not prevented by physical threats or other inappropriate non-market means.

Regards, Don

"willing to spend the most"

"willing to spend the most" != "maximized spending"

This is a very subtle point. In terms of conventional economic diagrammatics, what we want to maximize is consumer surplus or the area below the demand curve and above price. When other factors can vary, this area is not correlated with price or total expenditure! That is, presented with two worlds, where the only given information is the different prices of a good, or the different total expenditure on that good, we cannot guess which world has the greater willingness-to-pay.

Answer to Don Lloyd: Sorry

Answer to Don Lloyd:
Sorry if I may have been too cryptic. The main point I made is that maximization of profit to the suppliers, is not the same as maximization of utility (measured by level of consumption), and frequently they will be in conflict. This observation is true indpendently of whether the marginal cost is zero.

The models you described didn't specify whether barriers to entry exist in the profit-maximizing economy, but since generally there are very few perfectly contestable and open markets, I was assuming that the profit-maximizing (segments of the) economy will have significant barriers to entry - and I might have misunderstood you there, since from your answer to me I gather that you assume low barriers to entry ("as long as new entries of competitors are not prevented by physical threats or other inappropriate non-market means"). But, with low barriers to entry, there would be few segments of the economy where a single provider could maintain a dominant position - as dictated by Coase's reduction of transaction costs, in most segments there would be many players, and this wouldn't be the "profit-maximizing economy" you analyzed, but rather a conventional laissez-faire one.

Now, I would claim that in general (not always, but frequently) a single-supplier price will not be a true market price. The efficiency of the market stems to a large extent from avoiding the "holdout problem", caused by single-agent control of a resource, and subsequent rent-seeking behavior. The space here is too brief for a full analysis of the issue, but a single-supplier price may contain elements of a rent (the profit-maximizing price even more so), and it is very difficult to prove otherwise. Only the presence of a competitor, and the exit option for consumers, assures reduction of price to the marginal cost level, the true market price.

Now, I agree with you that the mere presence of a single supplier is not automatically deleterious - there may be certain segments of the economy where the economies of scale and reduction of transaction costs result in the stable formation of a single supplier, as in the production of aluminum and Alcoa - but, such situations make it quite difficult to ascertain true costs, which is likely to increase rent-seeking. Please note - I don't see this as a sufficient reason for government intervention in the form of anti-trust laws.

So, I strongly prefer the marginal-cost reducing economy, where multiple suppliers are present in all segments - which is best achieved by having large numbers of consumers connected by the globalization of trade that, by Coasian mechanisms, greatly reduces the threat of collusion and deleterious monopoly formation, without specific bans on company mergers.

Rafal, The main point I made

Rafal,

The main point I made is that maximization of profit to the suppliers, is not the same as maximization of utility (measured by level of consumption), and frequently they will be in conflict. This observation is true indpendently of whether the marginal cost is zero.

Maximization of consumption level is not an operational possibility since two states of consumption can only be unambiguously compared if all individuals consume the same or more of every good or service. Different goods cannot be summed and even the same good cannot summed over the disparate subjective valuations of different individuals.

The models you described didnâ??t specify whether barriers to entry exist in the profit-maximizing economy, but since generally there are very few perfectly contestable and open markets, I was assuming that the profit-maximizing (segments of the) economy will have significant barriers to entry - and I might have misunderstood you there, since from your answer to me I gather that you assume low barriers to entry ("as long as new entries of competitors are not prevented by physical threats or other inappropriate non-market means"). But, with low barriers to entry, there would be few segments of the economy where a single provider could maintain a dominant position - as dictated by Coaseâ??s reduction of transaction costs, in most segments there would be many players, and this wouldnâ??t be the â??profit-maximizing economyâ?? you analyzed, but rather a conventional laissez-faire one.

I am indifferent as to whether barriers to entry are high or low, but note that if low barriers result initially in many suppliers, that doesn't mean that, in the absence of artificial anti-merger rules, they will remain unconsolidated. Every good is different, and some will tend to completely consolidate and others will not. I'm perfectly content with this outcome.

Now, I would claim that in general (not always, but frequently) a single-supplier price will not be a true market price. The efficiency of the market stems to a large extent from avoiding the â??holdout problem", caused by single-agent control of a resource, and subsequent rent-seeking behavior. The space here is too brief for a full analysis of the issue, but a single-supplier price may contain elements of a rent (the profit-maximizing price even more so), and it is very difficult to prove otherwise. Only the presence of a competitor, and the exit option for consumers, assures reduction of price to the marginal cost level, the true market price.

I remain to be convinced that a concept of a 'true' market price is a useful concept. Marginal cost is largely an arbitrary result of history. If marginal cost pricing is enforced, this is a disincentive to investment.

Now, I agree with you that the mere presence of a single supplier is not automatically deleterious - there may be certain segments of the economy where the economies of scale and reduction of transaction costs result in the stable formation of a single supplier, as in the production of aluminum and Alcoa - but, such situations make it quite difficult to ascertain true costs, which is likely to increase rent-seeking. Please note - I donâ??t see this as a sufficient reason for government intervention in the form of anti-trust laws.

In this paragraph, I suspect I see a tendency to connect a single supplier with a vertically integrated supplier. These concepts may not be entirely independent, but they are certainly distinct.

So, I strongly prefer the marginal-cost reducing economy, where multiple suppliers are present in all segments - which is best achieved by having large numbers of consumers connected by the globalization of trade that, by Coasian mechanisms, greatly reduces the threat of collusion and deleterious monopoly formation, without specific bans on company mergers.

I find the threat of monopoly (in the single supplier sense, not in the granted privilege sense) less than convincing. As long as a monopoly supplier prices in his own self-interest he is subject to the price-dependent demand of consumers and the potential competition of new entrants. Potential competition is comparably as effective in holding down prices and maintaining quality as is actual competition, without the duplication of fixed costs and infrastructure.

Regards, Don